Washington and Lee Law Review

Volume 52 | Issue 4 Article 8

Fall 9-1-1995

Broker-Dealer Sales Practice in DerivativesTransactions: A Survey and Evaluation ofSuitability RequirementsDaniel G. Schmedlen, Jr.

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Recommended CitationDaniel G. Schmedlen, Jr., Broker-Dealer Sales Practice in Derivatives Transactions: A Survey andEvaluation of Suitability Requirements, 52 Wash. & Lee L. Rev. 1441 (1995),https://scholarlycommons.law.wlu.edu/wlulr/vol52/iss4/8

Broker-Dealer Sales Practice in DerivativesTransactions: A Survey and Evaluation of

Suitability Requirements

Daniel G. Schmedlen, Jr.*

Table of ContentsI. Introduction ................................ 1442

II. Derivatives Basics ........................... 1445A. Uses of Derivatives ....................... 1448B. Risks Involved in Derivatives Transactions ........ 1449C. A Comparison of Exchange-Traded Derivatives and

OTC Derivatives ......................... 1452III. Current and Proposed Laws and Regulations Governing

Dealer Sales Practices in OTC Derivatives Transactions ... 1454A. A Summary of Current Laws and Regulations Affecting

OTC Derivatives Dealers .................... 14551. Regulation of Derivatives Dealers Sales Practice

by the SEC and CFTC .................... 1456a. Suitability Requirements ............... 1456b. Antifraud Provisions ................. 1457

2. Regulation of Derivatives Dealers by FinancialInstitution Regulators ................... 1464

B. A Summary of the GAO Report's RecommendationsConcerning Regulation of OTC Derivatives Dealers . . 1467

C. Proposed Legislation Affecting Suitability Requirementsfor OTC Derivatives Dealers ................. 1469

IV. An Analysis of OTC Derivatives Dealer SuitabilityRequirements .............................. 1470

V. Conclusion ................................ 1474

* The author wishes to thank Lyman P.Q. Johnson, Michael A. Bosh, HowardKramer, Daniel G. Schmedlen, Sr., and Jeanne Schmedlen for their helpful suggestions.

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"[T]hese guys have done some pretty wild stuff. And you know, theyprobably do not understand it quite as well as they should. I think thatthey have a pretty good understanding of it, but not perfect. And that'slike perfect for us. "'

I. Introduction

A derivative financial instrument (derivative) is a bilateral contract thatis linked to, or derives its value from, the value of an underlying security,index, or reference rate.2 The derivative securities industry has "boomed"in the past two years.3 Merrill Lynch & Co., the nation's largest brokeragefirm, experienced a fifty-seven percent increase in derivatives tradingrevenue from 1992 to 1993.' The notional value5 of all derivatives contractsentered into by United States-based commercial banks increased from $11.8trillion at the end of 1993 to over $15.5 trillion in September of 1994.6

Enthusiasm about derivatives, however, has turned to paranoia becauseof recent staggering losses sustained by derivatives end-users.7 In December

1. BT Securities Corp., Securities Act Release No. 7,124, Exchange Act Release No.35,136, Fed. Sec. L. Rep. (CCH) 85,477 (Dec. 22, 1994) (quoting derivatives dealer'scomments regarding unsophisticated customer).

2. See infra note 25 and accompanying text (definig derivative financial instrument).3. See Nicholas Bray, Two Agencies Issue Guidelines on Derivatives, WALL ST. J.,

July 27, 1994, at A6 (describing derivatives market as "booming").4. Michael Siconolfi, Merrill Lynch Says Derivatives Revenue Swelled 57% to $761

Million Last Year, WALL ST. J., Mar. 17, 1994, at A10.5. The "notional amount" in a derivatives transaction is the amount of the underlying

asset. See GAO REPORT, infra note 16, at 28 n.7 (explaining notional amounts in derivativestransactions). Regulators aggregate the notional amount of each derivatives transaction todetermine trends in the derivatives markets. Id. at 28. In a swap agreement, parties calculatetheir obligations by multiplying the value of the underlying security, index, or reference rate(for example, an interest rate) by the notional amount (for example, $10 million). TelephoneInterview with Merrill Lynch & Co. (Feb. 23, 1995); see also infra note 31 (explaining swapagreements). Generally, parties do not exchange the notional amount in a swap. GAOREPORT, infra note 16, at 28 n.7 For forwards, futures, and options, regulators use theamount of the contract as the notional value for measuring the volume of each contract. Id.,see also infra note 27 (explaining forwards, futures, and options).

6. OFFiCE OF THE COMPTROLLER OF THE CURRENCY, 3D QUARTER 1994 CALL REPORTON DERIVATIVES ACTIVITIES OF UNITED STATES COMMERCIAL BANKS (Feb. 8, 1995) (on filewith the Capital Markets Division of the Office of the Comptroller of the Currency).

7 In the derivatives market, end-users are market participants that enter into deriva-tives transactions for their own accounts. See mfra note 44 and accompanying text (definingend-users). End-users use derivatives to manage risks, to speculate on market movements,to obtain better financing terms, and to diversify their investment portfolios. See infra notes

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1993, a New Y6rk unit of Metallgesellschaft AG, a German company,reported a loss of over $1 billion resulting from trading m oil-based deriva-tives.8 In April 1994, Proctor & Gamble Co. (P&G) disclosed that P&Gwould take a $157 million charge to cover interest rate derivatives lossessustained over a period of less than two months.9 In the aftermath of P&G'sannouncement, Comnnssioner Richard Roberts of the Securities and Ex-change Commission (SEC) correctly predicted that more companies wouldsoon reveal losses attributable to derivatives trading.' 0 Indeed, by the endof 1994, several mutual funds, municipalities (most notably Orange County,California), and companies had announced losses, some of them staggering,that resulted from derivatives transactions." By August 1994, derivativestrading had accounted for nearly $6.4 billion m losses since 1993.12

A number of end-users that suffered large losses due to derivativestransactions filed suit against the dealers that sold them the derivatives. 3

48-52 and accompanying text (describing ways in which end-users use derivatives).8. Bray, supra note 3, at A6.9. Gabriella Stem & Steve Lipm, Proctor & Gamble to Take a Charge to Close Out

Two Interest-Rate Swaps, WALL ST. J., Apr. 13, 1994, at A3.10. Roberts Sees More Losses From Derivatives Trading, WALL ST. J., Apr. 29, 1994,

at Cl.11. See Karen Slater Damato, Examnming Your Mutual Funds for Derivatives Risk,

WALL ST. J., Aug. 11, 1994, at Cl (listing mutual funds that suffered heavy losses in deriva-tives); G. Bruce Knecht, I Owe U.. How a Texas College Mortgaged its Future in DerivativesDebacle, WALL ST. J., Sept. 23, 1994, at Al (explaining how college's investment portfoliolost half its value over nine month period due to decrease m value of derivatives); G. BruceKnecht, Pied Piper: Minneapolis Investors Are Hurt.by Local Firm They Knew as Cautious,WALL ST. J., Aug. 26, 1994, at Al (reporting that institutional funds managed by PiperJaffray suffered $700 million in losses due to decrease m value of derivatives); James PMiller, -Air Products Takes a Charge of $60 Million, WALL ST. J., May 12, 1994, at A3(reporting that Air Products & Chemicals Inc. took $60 million charge to reflect decliningvalue of derivatives); Orange County Crisis - Local Heroes: Public Finance Chiefs Are VeryOften Bonng; That's the Good News, WALL ST. J., Dec. 8, 1994, at Al (reporting that nearly20 municipalities m Ohio have claimed losses of $14 million incurred m derivatives trans-actions).

12. See Randall Smith & Steven Lipm, Beleaguered Giant: As Derivatives Losses Rise,Industry Fights to Avert Regulation, WALL ST. J., Aug. 25, 1994, at Al (reporting losses mderivatives transactions).

13. See Knecht, supra note 11, at Al (reporting that Odessa College sued derivativesdealer to recover $11 million m derivatives trading losses); Steven Lipm, Bankers Trust Suedon Derivatives, WALL ST. J., Sept. 13, 1994, at Cl (reporting that Gibson Greetings Inc.sued derivatives dealer to recover $23 million in derivatives trading losses);. Paulette Thomas,Proctor & Gamble Sues Bankers Trust Because of Huge Losses on Derivatives, WALL ST. J.,Oct. 28, 1994, at A6 (reporting that Proctor & Gamble Co. sued derivatives dealer to recover

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The end-users claimed that they had not understood what they were buyingand accused the dealers of taking advantage of the end-users' ignorance. 4

In November 1994, one such end-user, Gibson Greetings, Inc., settled itssuit against BT Securities Corporation, a derivatives dealer, for $14 mil-lion. '5

On May 18, 1994, the General Accounting Office (GAO), in responseto a request from Congress, issued a report (GAO Report) on derivativesactivity 16 The GAO Report concluded that current over-the-counter (OTC)derivatives trading practices posed a serious danger to the financial systemof the United States and called for formal regulations governing OTC deriva-tives trading.17

In response to the heightened-concern about insufficient OTC deriva-tives controls, members of Congress introduced six bills during the firstseven months of 1994 that would provide for enhanced supervision of, andlimitations on, OTC derivatives trading.'" The bills propose a wide range

$130 million in derivatives trading losses).14. See G. Bruce Knecht, The Lawyers' Turn: Derivatives Are Going Through Crucial

Test: A Wave of Lawsuits, WALL ST. J., Oct. 28, 1994, at Al (reporting that customers mderivatives lawsuits alleged that derivatives dealers took advantage of customers' lack ofsophistication).

15. See Steven Lipm, Gibson Greetings Reaches Accord in Suit Against Bankers TrustOver Derivatives, WALL ST. J., Nov 25, 1994, at A2 (reporting that Gibson Greetings Inc.settled suit with derivatives dealer). Gibson Greetings lost over $20 million m derivativestransactions recommended by BT Securities Corp. Id. The settlement provided that Gibsonwould have to pay only $6.2 million of those losses. Id.

16. GENERAL ACCOUNTING OFFICE, FINANCIAL DERIVATIVES: ACTIONS NEEDED TOPROTECT THE FINANCIAL SYSTEM (1994) [hereinafter GAO REPORT].

17 Id. at 123-24.18. See S. 2291, 103d Cong., 2d Sess. § 3(a) (1994) (limiting FDIC insured mstitu-

tion's ability to purchase, sell, or engage in any transaction involving derivative financialinstrument); H.R. 4745, 103d Cong., 2d Sess. § 2 (1994) (providing framework for SECsupervision and regulation of all derivatives activities including counterparty agreements);H.R. 4503, 103d Cong., 2d Sess. § 101 (1994) (calling for establishment of substantiallysimilar oversight guidelines for federally insured financial institutions engaged in transactionsinvolving derivative financial products by federal regulatory agencies and mandating riskevaluation procedures for federally insured financial institutions); S. 2123, 103d Cong., 2dSess. § 2 (1994) (amending Federal Deposit Insurance Act to prohibit federally insured insti-tutions and their affiliates from engaging in nonhedgmg transactions involving derivativefinancial instruments); H.R. 4170, 103d Cong., 2d Sess. § 2 (1994) (providing for delineateddisclosure requirements of derivative financial instruments by federally insured financialinstitutions); H.R. 3748, 103d Cong., 2d Sess. § 101 (1994) (establishing Federal DerivativesCommission to promulgate principles and standards for federal oversight of federally insuredfinancial institutions).

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of -solutions, ranging from the creation of a Federal Derivatives Commis-sion 9 to a general prohibition forbidding banks from engaging m derivativestransactions that do not qualify as "hedging."' The 103d Congress, how-ever, never voted on the proposals. Early in 1995, members of the Houseof Representatives introduced two more bills governing derivatives.21

Tins Note analyzes the state of OTC derivative securities sales practice,including the current regulatory scheme and proposed revisions. Part II ofthis Note defines derivative financial instruments and describes their associ-ated risks and benefits.' Part I examines the current regulatory frameworkgoverning broker-dealer sales practice m OTC derivatives transactions andanalyzes the GAO Report and pending legislation providing for stricter regu-lation.' Part IV evaluates the present and proposed schemes for regulatingbroker-dealer sales practice m OTC derivatives transactions. 24

II. Derivatives Basics

A derivative financial instrument is a bilateral contract that is linked to,or derives its value from, the value of an underlying security, index, or ref-erence rate (an underlying).' Underlymgs can include securities, coimodi-ties, indexes, currency rates, and interest rates.' Every derivatives transac-tion includes options, forward-based instruments, or a combination of both.27

19. See H.R. 3748, 103d Cong., 2d Sess. § 103 (1994) (proposing establishment of"Federal Derivatives'Commission").

20. See S. 2123, 103d Cong., 2d Sess. § 2 (1994) (proposing amendment of FederalDeposit Insurance Act to generally prohibit, with some exceptions, FDIC insured institutionsfrom engaging in any transaction involving derivatives). Hedging is a risk managementtechnique. See infra note 48 (defining hedging).

21. See H.R. 20, 104th Cong., 1st Sess. § 101 (1995) (establishing Federal DerivativesCommission to promulgate principles and standards for federal oversight of federally insuredfinancial institutions); H.R. 31, 104th Cong., 1st Sess. §§ 101, 301, 401, 501 (1995)(providing for increased disclosure of derivatives positions by financial institutions, forcertain insolvency reforms concerning derivatives, for international regulatory cooperation,and for new study of speculation, margin, and collateral requirements by GAO).

22. See nfra notes 25-91 and accompanying text (describing derivatives).23. See infra notes 92-208 and accompanying text (examining current and proposed

regulatory frameworks for oversight of derivatives).24. See infra notes 209-35 and accompanying text (evaluating current and proposed

schemes for regulating derivatives).25. See GAO REPORT, supra note 16, at 24 (defining derivative financial instrument).26. See id. (listing examples of underlying assets in derivative instruments).27 See GROUP OF THIRTY, infra note 62, at 29 (stating that options and forward-based

instruments are "building blocks" of all derivatives). An option contract gives the option

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Market participants can, and often do, combine simple derivatives, such asoptions,2 futures,29 and forwards' to form more complex instruments, suchas swaps," caps, floors, collars,32 and others.33

holder, m exchange for payment of a premium, the right, but not the obligation, to buy or sellan underlying (or settle the value for cash) at a price, called the strike price, during a timeperiod or on a specific date. Id. at 32. Forward-based instruments include both forwardcontracts and futures contracts. Id. at 30, 32. A forward contract is an "over-the-counter"agreement that obligates one counterparty to buy, and the other to sell, a specific underlyingat a specific price, amount, and date. Id. at 30. Futures are a type of forward-based contractthat trade on organized exchanges. Id. at 32. Futures differ from forwards in that the termsof a futures contract are standardized, while the terms of a forward contract are not stan-dardized, but instead left to the parties to determine. Id. at 30, 32. Exchanges regulate thetrading of futures and some option contracts, while market participants negotiate forwardcontracts and other option contracts privately, that is, over-the-counter. See GAO REPORT,supra note 16, at 4-5 (describing ways in which market participants trade derivatives).

28. See supra note 27 (discussing options); see generally THE OPTIONS INST., CHCAGOBD. OPTIONS EXCH., OPTIONS: ESSENTIAL CONCEPTS AND TRADING STRATEGIES (1990)(same) [hereinafter THE OPTIONS INST.].

29. See supra note 27 (describing futures); see generally TODD LOFTON, GETrINGSTARTED IN FTREs (1989) (discussing futures and providing comprehensive bibliography).

30. See supra note 27 (describing forward contracts).31. See GROUP OF THIRTY, infra note 62, at 31 (describing swaps). A swap transaction

is an over-the-counter bilateral agreement obligating two parties to exchange a series ofpayments at specified intervals known as settlement dates. Id. Parties either fix the paymentsof a swap or, more commonly, calculate the payments for each settlement date by multiplyingthe quantity of the underlying (the notional amount) by specified reference rates or prices.Id. Each party to a swap makes payments calculated by a different formula. Id. Partiesgenerally net interim payments, with one party paying the difference to the other. Id. Insimplest terms, a swap is a series of forward contracts. Id.

32. See id. at 33 (describing caps, floors, and collars). Like a swap, a cap transactionentails a series of periodic payments. Id. The buyer of a cap instrument pays a premium tothe seller and at each payment date, receives from the seller a payment equal to the differ-ence, if positive, between a reference rate (which is variable) and a strike rate ("cap") multi-plied by a notional amount. Id. A floating-rate borrower might use a cap to protect againsta rise in interest rates. Id. A floor contract is the opposite of a cap in that the seller must paythe buyer only if the difference between the reference rate and the strike rate (here, the"floor") is negative. Id. Therefore, a floor protects a floating-rate investor against a declinein interest rates. Id. Buying a collar is equivalent to buying a cap and selling a floor. Id.

33. See id. at 30-34 (describing complex derivatives). Other types of complex deriva-tives include "swaptions" (options on swaps) and options on futures contracts. See id. at 33-34 (describing swaptions and futures options). Some market participants include within thedefinition of derivatives a wide variety of debt instruments that have pay-off characteristicsreflecting embedded derivatives (for example, "structured notes"), or have option character-istics, or are created by "stripping" particular components of other instruments such asprincipal or interest payments. See id. at 29 (describing financial instruments that might meetthe definition of "derivative").

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As with any contract, each derivatives transaction involves at least, andusually no more than, two parties, called counterparties. 4 In addition, a de-rivatives contract obligates both counterparties to undertake some perfor-mance.3" In a transaction involving an exchange-traded derivative, thecentral exchange is a counterparty 36

Participants in the derivatives market fall into two distinct categories:broker-dealers (dealers) and end-users.37 Dealers act in two capacities.First, dealers sell derivatives contracts involving other counterparties.3" Forexample, a dealer might sell to a client a derivative instrument to which theFederal Home Mortgage Association is a counterparty '9 Second, dealersoffer and enter into derivatives transactions in which the dealers themselvesare counterparties. 4 For example, swaps dealers commonly quote bids andoffers at which they are willing to enter into swaps as a counterparty 41 De-rivatives dealers include banks, securities firms, insurance companies, andaffiliates of each.42 Dealers normally profit from derivatives trading bycharging fees or earning returns from bid-ask spreads.43

In derivatives transactions, end-users are the counterparties that are notdealers." End-users can include corporations, financial institutions, govern-

34. See id. at 30 (calling parties to derivatives transaction "counterparties").35. See supra notes 27, 31, 32 (describing rights and obligations of participants m

various derivatives transactions).

36. See GROUP OF THIRTY, mfra note 62, at 32 (stating that exchanges are parties toderivatives contracts traded on organized exchanges).

37 See id. at 34 (categorizing all derivatives market participants as either dealers orend-users).

38. See id. at 41 (explaining dealer's role m brokering derivatives transaction betweencounterparties).

39. See Telephone Interview with Merrill Lynch & Co. (Feb. 23, 1995) (describingdealer-customer relationships m OTC derivatives market).

40. See GROUP OF THIRTY, infra note 62, at 42 (describing evolution of derivativesdealer's role from broker to counterparty).

41. Christopher L. Culp & Robert J. Mackay, Regulating Denvatives: The CurrentSystem and Proposed Changes, REGULATION, Fall 1994, 38, 39 (describing participants mOTC derivatives markets).

42. See GAO REPORT, supra note 16, at 30 (listing types of institutions that act asderivatives dealers).

43. See GROUP OF THRTY, mfra note 62, at 42 (describing ways m which dealers profitfrom derivatives trading). Normally, derivatives dealers structure their asking prices forentering into derivatives transactions to include a margin of profit. Id.

44. See id. at 34 (stating that derivatives market participants are either dealers or end-users).

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ment entities, individual investors, and institutional investors.45 Dealers sellderivatives to, and enter into derivatives contracts with, end-users. 46 Partici-pants m the derivatives market are often both dealers and end-users.47

A. Uses of Denvatives

End-users can use derivatives in at least four ways. First, end-users canuse derivatives to manage risk by "hedging"''4 against adverse changes in thevalues of the underlying assets or other related investments within a port-folio.49 Second, end-users can use derivatives to speculate on anticipatedchanges in the values of the underlying assets.' ° Third, end-users can usederivatives to obtain better financing terms."' Finally, end-users can usederivatives to diversify their investment portfolios. 2

45. See GAO REPORT, supra note 16, at 29 (listing classes of derivatives market par-ticipants that act as end-users).

46. See supra notes 39, 41 and accompanying text (describing transactions betweendealers and end-users).

47 See GROUP OF THIRTY, infra note 62, at 34 (stating that participants in derivativesmarket may act as both dealer and end-user). But see GAO REPORT, supra note 16, at 29-30(implying that participants in derivatives market are either dealers or end-users, but not both).

48. See JOSEPH D. KOZIOL, HEDGING PRINCIPLES, PRACTICES, AND STRATEGIES FORTHE FINANCIAL MARKETS 3 (1990) (defining hedging as process of dynamically managingrisks by using "offset mechanism"). For example, if the value of a position decreases by$100, the offset mechanism (the hedge) should increase in value by $100. Id. Likewise, ifa position increases in value by $500, the value of the hedge should decrease by $500. Id.

49. See id. at 4-6 (observing that four basic methods of establishing hedges all involveuse of derivatives). Specifically, hedging involves contractual agreements (including swaps),forward contracts, futures contracts, and options contracts. Id.

50. See THE OPTIONS INST., supra note 28, at 69-82 (describing speculation strategiesinvolving derivatives).

51. See GAO REPORT, supra note 16, at 25 (observing that some derivatives enablemarket participants to obtain better financing terms). Derivatives allow market participantsto improve their financing terms by enabling participants to work together to take advantageof differences in the rates and terms under which participants borrow money Id. In addi-tion, derivatives enable participants to more effectively and efficiently hedge their risks, andthereby improve their creditworthiness. Id.

52. See James E. Rhodes & Carol W Proffer, To Hedge or Not to Hedge? (Parts I &I1), in MANAGING CURRENCY RISK 4, 5, 10 (Mark P Kritznan & Katrina F Sherrerd eds.,1989) (explaining that ability to hedge currency risk encourages investment in foreign marketsand that three most commonly used methods of hedging currency risk all involve derivatives).But see Fischer Black, Universal Hedging, in MANAGING CURRENCY RISK, supra, at 28-30(asserting that because currency rate movements often correlate to market movements, someindirect currency risk is unavoidable notwithstanding use of derivatives).

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Investing m some derivatives can be more cost-effective than investingm the underlying assets. For example, an option to buy or sell an underly-ing asset usually costs a fraction of the price of the underlying asset.53

Because investing m derivatives often involves a great deal of leverage,derivatives can offer investors much higher returns than nonderivativeinstruments when the market moves in a favorable direction.' The con-verse, however, also is true. Losses are proportionally much higher whenthe market moves m an unfavorable direction.55

B. Risks Involved in Denvatives Transactions

The risks involved in derivatives trading - market risk,56 credit nsk,5

53. See Lee Berton, Understanding the Complex World of Derivatives, WALL ST. J.,June 14, 1994, at Cl (observing that option's price is usually small percentage of underlyingasset's value).

54. See id. (noting that leverage factor m transaction involving option can magnifygains m value of option). For example, suppose that the price of ABC's stock is $50/shareand that the price of a 90-day call option on ABC's stock, with a strike price of $50, is$2/option. See Telephone Interview with Merrill Lynch & Co. (Feb. 23, 1995) (explainingleverage in options transactions). An investor, with $10,000 to invest, expects the price ofthat stock to rise to $55/share during the next three months. Id. The investor can either buy200 shares of ABC's stock at $50/share or 5,000 call options at $2/option for $10,000. Id.Suppose, as the investor hoped, that the price of ABC's stock rises to $55/share duringthe three month period. Id. If the investor had purchased 200 shares of stock at $50/shareand sold them at $55/share, the investor would realize a $1,000 profit. Id. On the other,hand, if the investor had purchased 5,000 options at $2/option and sold the options at marketvalue, the investor would enjoy a $15,000 profit. Id. As the stock's price increases, thevalue of that stock's call options also rises. Id. In this case, the lowest reasonable price ofa call option with a strike price of $50 is $5 (the stock price, $55/share, minus the optionstrike price, $50). Id. Therefore, the investor's 5,000 options would be worth a total of$25,000, yielding a $15,000 profit for the investor's initial $10,000 investment. Id. Insummary, the investor would achieve a 10% return by investing in ABC's stock, comparedwith a 150% return by investing the same amount of money m the corresponding call op-tions. Id.

55. Telephone Interview with Merrill Lynch & Co. (Feb. 23, 1995). For example,using the fact scenario from note 54, supra, if the investor purchased 5,000 options exer-cisable at $50/share and the price of ABC's stock fell and remained at $49/share, the optionswould be worthless and the investor would lose the entire $10,000 investment. Id. Bycontrast, if the investor had purchased the actual stock at $50/share, the investor would loseonly $200, or 2% of the investment. Id.

56. See nfra notes 63-65 and accompanying text (defining and describing market riskin derivatives transactions).

57 See infra notes 66-68 and accompanying text (defining" and describing credit riskin derivatives transactions).

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operational risk,5" and legal risk59 - are identical to the risks involved mmany other traditional financial activities.' Risks associated with deriva-tives, however, are more difficult to measure.61 The Group of Thirty, aninternational financial policy organization composed of representatives ofcentral banks, the financial industry, and academia, described the types ofrisks involved m derivatives transactions m a 1993 study 62

The Group of Thirty's study defined "market risk" as the exposure toa change m the value of a derivative when market conditions change.63 If aderivative is part of a portfolio, the overall exposure of the portfolio deter-mines the market risk.64 The GAO Report observed that the many factorsthat affect market risk make measuring and managing market risk "difficult"and "extremely complicated," especially in cases involving large and diverseportfolios.65

58. See infra notes 69-70 and accompanying text (defining and describing operationalrisk in derivatives transactions).

59. See infra notes 71-73 and accompanying text (defining and describing legal risk inderivatives transactions).

60. See GAO REPORT, supra note 16, at 44 (noting similarity of risks inherent inderivatives and other financial transactions); GROUP OF THIRTY, infra note 62, at 43 (same);Culp & Mackay, supra note 41, at 6 (same).

61. Telephone Interview with Merrill Lynch & Co. (Jan. 30, 1995); see infra notes 65,68 and accompanying text (describing difficulties in assessing risk in derivatives transactions).Derivatives dealers use sophisticated computer models to value derivatives and predict pricetrends. Telephone Interview with Merrill Lynch & Co., supra.

62. See THE GROUP OF THIRTY, DERIVATIVES: PRACTICES AND PRINCIPLES, 43-52(1993) (describing risks involved in derivatives transactions).

63. See id. at 43-44 (defining market risk in derivatives transactions). The Groupof Thirty's study identified six factors that determine the market risk of a derivative:(1) "absolute price or rate risk," which is the exposure to a change in the value of thederivative (or portfolio) corresponding to a given change in the price of an underlying;(2) "convexity risk," which is the risk that arises when the relationship between a change inthe value of a derivative (or portfolio) and the price of the underlying is not linear;(3) "volatility risk," which is the exposure to a change in the value of a derivative (or port-folio) resulting from a given change in the expected volatility of the price of the underlying;(4) "time decay risk," which is the exposure to a change in the value of a derivative (orportfolio) arising from the passage of time; (5) "basis or correlation risk," which is theexposure to a change m the value of a derivative (or portfolio) resulting from differences mthe price performance of the sub-derivatives (or derivatives) that the derivative (or portfolio)contains, and their hedges; and (6) "discount rate risk," which is the exposure to a change inthe value of a derivative (or portfolio) corresponding to a change in the rate discountingfuture cash flows. Id.

64. Id. at 43.65. GAO REPORT, supra note 16, at 60-61.

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"Credit risk" is the risk of loss due to a counterparty's default on aderivatives contract.6 Determining the credit risk involved in a single deriv-atives transaction often requires a participant to evaluate both current andpotential credit exposures because the credit exposure can change dramat-ically over the life of a derivative.67 Determining the credit risk involved in

a portfolio, on the other hand, requires a complex assessment of offsettingexposures, netting agreements with each particular counterparty, and thetiming relationship among transactions in order to produce peak maximumpotential exposures at different times.6" "Operational risk," according to theGroup of Thirty, is the risk of loss occurring as a result of inadequate sys-tems and control, human error, or management failure on the part of apartiipant.69 The Group of Thirty further noted that the complexity in-

volved in many derivatives transactions requires special emphasis on main-taming adequate controls to assess and monitor both the transactions and theaggregate position:of a derivatives market participant. 70

"Legal risk" is the risk of loss because a derivatives contract is legallyunenforceable, including risks arising from msufficient documentation, in-sufficient capacity or authority of a counterparty, uncertain legality, and

66. See id. at 52 (defining credit risk); GROUP OF THIRTY, supra note 62, at 47 (same);Culp & Mackay, supra note 41, at 40 (same).

67 See GROUP OF THIRTY, supra note 62, at 47 (noting two questions that one shouldask when assessing credit risk involved in individual derivatives contract). According to theGroup of Thirty, one must ask two questions: (1) "If a counterparty was to default today,what would it cost to replace the transaction?" and (2) "If a counterparty defaults at someother point in the future, what is a reasonable estimate of the potential replacement cost?"Id. Credit risk exposures in a derivatives transaction can change rapidly and dramatically,especially in highly leveraged situations. Id. at 52-54.

68. See id. at 48-49 (explaining factors used in determining-credit risk of entire port-folio which include transactions with more than one counterparty).

69. See id. at 50 (defining operational risk). The Group of Thirty study also listedexamples of internal controls that participants engaged in derivatives trading commonly use:(1) oversight by informed and involved senior management, (2) documentation of standardpolicies and operating procedures including limits and exceptions, credit controls, andmanagement reports, (3) independent risk management (analogous to credit review andasset/liability committees) that provides senior management with validation of results andutilizations of limits, (4) independent internal audits that verify adherence to the firm'spolicies and procedures, (5) technology and systems for handling day-to-day events, and (6) asystem of independent checks and balances throughout the transaction process, from front-office initiation of a trade to final payment settlement. Id.

70. Id. at 57; see also GAO REPORT, supra note 16, at 67 (stating that complexity ofdenvatives transactions makes developing adequate risk management procedures'and controlsdifficult).

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52 WASH. &LEE L. REV 1441 (1995)

unenforceability due to bankruptcy or insolvency " The GAO Reportobserved that some derivatives face uncertain treatment under the gamblinglaws of some countries.72 Derivatives involve more legal risk than standardfinancial transactions because of the innovative quality of derivatives.73

Experts have -suggested that derivatives also present "liquidity risk,"which can involve both "market liquidity risk" and "funding risk. "74 "Mar-ket liquidity risk" is the risk that a large transaction in a particular instru-ment could have an adverse impact on market price.75 "Funding risk," onthe other hand, is the risk that problems in a participant's internal cash flowmay cause contractual nonperformance and force the liquidation of theparticipant's position.76

C. A Companson of Exchange-Traded Denvatives and OTC Denvatives

Exchange-traded derivatives, such as futures and sorne options, offerthe advantage of a central clearing house - the exchange itself.7 Com-

71. See GROUP OF THMRTY, supra note 62, at 51 (describing various types of legal risksin derivatives transactions). See generally LAURENCE D. DOBOSH & FLORENCE D. NOLAN,CERTAIN ISSUES RELATING TO ENFORCEABILITY OF OTC DERIVATIVES (1994) (discussinglegal risks in OTC derivatives transactions). For example, in January 1991, the United King-dom House of Lords held that a London borough lacked the necessary capacity to enter intointerest rate swap contracts that the borough had entered into during the 1980s and, therefore,did not have to fulfill the contracts. GROUP OF THIRTY, supra note 62, at 51.

72. See GAO REPORT, supra note 16, at 65 (noting that gambling laws of Brazil, Can-ada, and Singapore may forbid sale of some types of derivatives).

73. See id. at 64-65 (observing that uncertainty lingers over legality of some forwardscontracts and netting agreements). The GAO Report noted that notwithstanding the adoptionof the Futures Trading Practices Act of 1992, Pub. L. No. 102-546, 106 Stat. 3590 (1992),a risk that a swap contract violates the Commodity Exchange Act, 7 U.S.C. §§ 1-24 (Supp.V 1993), still exists because a court might hold that the swap is an illegal off-exchange futurescontract. Id. For an in-depth treatment of the effects of the Futures Trading Practices Actof 1992 on the derivatives markets, see Rebecca Leon, Note, The Regulation of Derivativesand the Effect of the Futures Trading Practices Act of 1992, 3 J.L. & POL'Y 321 (1994).

74. See Culp & Mackay, supra note 41, at 41 (stating that institutions engaged in deriv-atives transactions can face two types of liquidity risks); see also GROUP OF THIRTY, supranote 62, at 46-47 (categorizing liquidity risks as market risks).

75. See Culp & Mackay, supra note 41, at 41 (describing market liquidity risk).76. See id. (describing funding risk). Culp and Mackay stated that a failure in funding

risk management was responsible for the $1.3 billion loss reported by Metallgesellschaft AG.Id. Specifically, the authors cited Metallgesellschaft's inability to generate cash to financevariation margin payments on futures positions that were hedging OTC transactions as thecause for the enormous losses. Id.

77 See supra note 27 (explaining organized exchanges); see also DONALD J.MATHIESON ET AL., MANAGING FINANCIAL RISKS IN INDEBTED DEVELOPING COUNTRIES 9

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SUITABLITYREQUIREMENTS

monly, only "clearing" members may make trades through the exchange,and other members or investors must transact through clearing brokers."Clearing members traditionally impose margin requirements on their custom-ers that are analogous to performance bonds and hereby reduce the creditrisk involved in the transactions.7 9 However, because a typical marginagreement requires a participant to post both an initial margin outlay andsubsequent daily maintenance outlays,"m exchange-traded derivatives canimpinge on a participant's cash flow throughout the life of the contract."1 Onthe other hand, OTC derivatives transactions usually provide for the settle-ment of profit or loss either at the expiration of the contract or at infrequentifftervals.Y

Exchanges often subject clearing brokers to net worth requirements andother conditions designed to reduce credit risks.8 3 In addition, as a clearing-house, the exchange is a party in every contract and guarantees contractperformance.' The exchange-traded derivatives markets also offer theadvantage of more liquidity than the OTC derivatives market and therebyallow participants to more quickly adjust their positions as economic condi-tions change.'

(1989) (comparing exchange-traded derivatives contracts with OTC derivatives transactions).78. See MATHIESON ET AL., supra note 77, at 9 n.24 (observing that only "clearing"

members of exchange may clear trades through clearinghouse).79. See id. (stating that clearing members often impose additional margin requirements

on their customers, thereby reducing credit risk involved in transactions).80. See id. at 32-33 (observing that acquiring futures market position in 200 contracts

of sugar would require initial outlay of $700,000 and could require daily maintenance marginoutlays of up to $112,000).

81. See d. (noting that holding futures market position could require daily maintenanceoutlays).

82. See GROUP OF THIRTY, supra note 62, at 31 (observing that swaps normally providefor payments at infrequent intervals); Dean D'Onofno, Using Derivatives to Execute Cur-rency Strategies, In MANAGING CURRENCY RISK, supra note 52, at 54-55 (comparing settle-ment in forward contracts and futures contracts).

83. See MATHIESON ET AL., supra note 77, at 9 (observing that exchanges commonlyimpose requirements designed to reduce credit risks on clearing members).

84. See id. (noting that because exchanges are parties to each derivatives contract tradedon exchanges, credit risk involved in exchange-traded derivatives is minimal). The resourcesof the exchange, rather than those of any single individual trader, guarantee each transaction.Id.

85. See GROUP OF THIRTY, supra note 62, at 32 (observing that exchange-tradedderivatives market is more liquid than OTC derivatives market); MATHIEsON ET AL., supranote 77, at 9 (same).

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Unlike exchange-traded derivatives that fix transaction terms such asquantity and duration, the parties in an OTC transaction fix their ownterms.s6 This "customization" allows parties to acquire more efficient hedg-ing positions.87 In addition, OTC derivatives entail higher credit risks thanexchange-traded derivatives because settlement of an entire OTC transac-tion's profit or loss normally occurs either at expiration of the contract or atinfrequent settlement dates.88 Consequently, the size of payments m typicalOTC derivatives contracts greatly exceeds the payments in exchange-tradedcontracts.8 9 Compared with exchange-traded derivatives, OTC derivativestypically require higher administrative maintenance because of their com-plexity and lack of central clearing.' Therefore, using OTC derivativesusually costs more than using exchange-traded derivatives.9

II. Current and Proposed Laws and Regulations Governing DealerSales Practices in OTC Derivatives Transactions

The current regulatory framework governing sales practices in OTCderivatives transactions consists of an overlapping scheme of banking regula-tory agencies, the SEC (through the National Association of Securities Deal-ers (NASD)), and the Commodity Futures Trading Commssion (CFTC).Laws regulating sales practice generally fall into two categories: antifraudprovisions and suitability requirements. Antifraud provisions forbid the useof untruthful or misleading information and the omission of material in-formation in connection with the sale of certain derivatives. Suitabilityrequirements, on the other hand, impose a duty on dealers to ensure that aproposed transaction is appropriate for a customer.

86. See GAO REPORT, supra note 16, at 24 (observing that parties can "customize"OTC derivatives transactions); GROUP OF THIRTY, supra note 62, at 30 (stating that partiescustomize terms of forward contracts and swap agreements); MATHIESON ET AL., supra note77, at 8 (observing that parties can "customize" .OTC derivatives transactions).

87 See D'Onofrio, supra note 82, at 54 (stating that because forward contracts canentail virtually any currency, size, and maturity, forward contracts are ideal for most cash-flow hedgers, especially banks).

88. See GROUP OF THIRTY, supra note 62, at 31 (observing that swaps normally providefor payments at infrequent intervals); D'Onofrio, supra note 82, at 54-55 (explaining thattypical payment arrangements in forward contracts provide for cash settlement at close oftransaction).

89 See D'Onofio, supra note 82, at 55 (comparing payment arrangements in forwardcontracts and futures).

90. See id. (enumerating disadvantages of using forward contracts).91. See id. (stating that lack of central clearing entailed in forward contracts requires

participants to have good back office to trade at low administrative costs).

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A. A Summary of Current Laws and Regulations AffectingOTC Denvatives Dealers

The GAO Report identified three distinct groups of dealers in the OTCderivatives market: (1) dealers that are federally insured financial institutionsor affiliated with such financial institutions, (2) dealers that are subject tofederal securities or commodities regulators, and (3) other dealers. 92 Partici-pants in the first group include banks, thrifts, and certain bank affiliates.9'Participants in the second group include registered securities dealers andfutures commission merchants (FCMs).9 Participants in the third groupinclude the "unregulated" dealers - those not subject to regulation by eitherbank regulators or securities and commodity regulators.'

As with all financial regulation in the United States, the regulatoryscheme that governs participants involved in derivatives transactions is bifur-cated.96 Federal agencies subject derivatives dealers to both "institutional"regulation and "functional" regulation. 7 Institutional regulation is the regu-lation of participants' financial status and activities.98 Examples of institu-tional regulation include restrictions on permissible activities, obligations todisclose financial information, and minmum capital requirements. 99 Func-tional regulation is the regulation of transactions of financial instruments andthe markets in which the instruments trade."° Examples of functional regu-lation include transparency and price reporting obligations, antifraud andantimampulation restrictions, position limits, and suitability requirements.01

92. See GAO REPORT, supra note 16, at 69-91 (distinguishing participants subject tobank regulators from participants not subject to bank regulators).

93. See d. at 69, 85 (observing that federal bank regulators oversee nationally and statechartered banks, thrifts, bank holding companies, and bank affiliates); see also infra notes166-69 (describing statutory basis for jurisdiction of federal bank regulators).

94. See GAO REPORT, supra note 16, at 85 (identifying derivatives dealers regulatedby SEC and CFTC, but not by bank regulators).

95. See id. at 86 (identifying "unregulated" dealers as dealers not subject to either bankregulators or to securities and commodity regulators).

96. See Culp & Mackay, supra note 41, at 41 (describing derivatives regulatoryframework as bifurcated).

97 See d. (observing that regulations governing derivatives participants include both"institutional" regulation and "functional" regulation).

98. See id. (describing "institutional" regulation as regulation of institutions alone, asopposed to regulation of financial instruments or markets in general).

99. See id. at 9, 14 (listing examples of "institutional" regulation).100. See id. at 9, 16 (describing "functional" regulation as regulation of financial prod-

ucts and markets, as opposed to regulation of users of those products and markets).101. See id. at 16 (listing examples of "functional" regulation).

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The focus of this Note, sales practice regulation, falls within the class offunctional regulation.

1 Regulation of Derivatives Dealers Sales Practice by the

SEC and CFTC

a. Suitability Requirements

The SEC, through the NASD, imposes suitability requirements on OTCderivatives dealers that are registered securities dealers.l" Section 2(a) ofthe NASD's Rules of Fair Practice (RFP)03 provides that m recommendingto any customer the purchase, sale or exchange of any security, a dealermust have a reasonable belief that the recommendation is "suitable" for thecustomer."° In addition, RFP Section 2(b) requires a dealer to make rea-sonable efforts to obtain a "non-institutional" customer's financial status, taxstatus, investment objectives, and any other information considered to bereasonable in recommending securities transactions before the dealer exe-cutes the transactions. 05 Under Article V of the RFP, the NASD may ma-pose sanctions including censure, fines, and suspension or revocation ofmembership for violations of the RFP by a member dealer."es The RFPsuitability provisions most likely apply only to the sale of instruments thatqualify as "securities" under the Securities Act of 1933 (Securities Act),"mregulations thereunder, the Securities Exchange Act of 1934 (Exchange

102. See Securities Exchange Act of 1934 § 15A(b)(6), 15 U.S.C. § 78o-3(b)(6) (1988)(providing that rules of SEC, together with official securities self-regulatory organizations,such as National Association of Securities Dealers, shall regulate registered OTC securitiesdealers).

103. NATIONAL Assoc. OF SEC. DEALERS, RULEs OF FAIR PRACTICE, reprinted in NASDMANUAL (CCII) 2,152 [hereinafter RFP].

104. See id. at art. H, § 2(a) (mandating that dealers subject to regulation of NASDmust have reasonable grounds for believing that any dealer's recommendation concerningpurchase, sale, or exchange of security is suitable for customer). Section 2(a) provides thatthe grounds upon which the dealer is to base a reasonable belief are the facts, if any,disclosed by the customer regarding the customer's other security holdings, financial situa-tion, and needs. Id. The NASD evaluates dealers' sales efforts on the basis of whether theyreasonably represent "fair treatment" of the customer. NASD BOARD OF GOVERNORS, SR-NASD-94-49 (1994).

105. See RFP, supra note 103, at art. I, § 2(b) (listing information useful in recom-mending securities transactions).

106. See id. at art. V, § 1 (listing sanctions for violation of RFP).107 See Securities Act of 1933 § 2(1), 15 U.S.C. § 77b(1) (1988 & Supp. V 1993)

(defining "security").

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Act)," 8 and regulations thereunder (collectively, the federal securitieslaws). 109 Neither the Commodity Exchange Act (CEA) nor regulationspromulgated thereunder by the CFTC address the issue of suitability

In early 1994, the SEC, the CFTC, and the United Kingdom Securitiesand Investments Board issued a joint statement setting forth an agenda forthe oversight of the OTC derivatives market, including the review of cus-tomer protection devices. 10 The joint statement requested relevant self-regu-latory organizations (SROs) to upgrade their suitability requirements toreflect the nature of the OTC derivatives market."' The joint statementsuggested that SROs ensure that a dealer, when recommending an OTCderivatives transaction to a customer, possess sufficient information aboutthe customer and the customer's resources to assess the suitability of thetransaction for the customer, including information indicating whether thecustomer has the capability to understand the risks involved in the transac-tion. "

2

b. Antifraud Provisions

The antifraud provisions of the federal securities laws". bear upon allderivatives dealers, including federally insured banking institutions andunregistered dealers, to the extent that dealers offer and sell instruments that

108. See Securities Exchange Act of 1934 § 3(10), 15 U.S.C. § 78c(10) (1988 & Supp.V 1993) (defining "security").

109. Compare RFP, supra note 103, at art. m, § 2(a) (expressly pertaining only to trans-actions involving securities) with id. at art. I, § 2(b) (pertaining to "the execution of a[recommended] transaction"). The NASD has advised that the art. Ill, § 2 suitabilityrequirements govern only the sale of securities. Telephone Interview with National Associa-tion of Securities Dealers, Inc. (Jan. 31, 1995). If a dealer recommended that a customerundertake a series of related transactions that involved both securities and nonsecurity deriva-tives instruments designed to act as hedges for such securities positions, the NASD wouldargue that if the securities transactions were not properly hedged, the entire transaction, bothsecurities and nonsecurities, would be unsuitable. Id.

110. SECURITIES AND EXCHANGE COMMISSION, COMMODITY FUTURES TRADING COM-

MISSION, AND SECuRrrIES AND INVESTMENTS BOARD, OTC DERIVATIVES OVERSIGHT 4 (1994)[hereinafter JOINT STATEMENT].

111. Id.112. Id.113. See Securities Act of 1933 § 17, 15 U.S.C. § 77q (1988) (forbidding fraud in sale

of securities); Securities Exchange Act of 1934 § 10(b), 15 U.S.C. § 78j(b) (1988) (forbid-ding contravention of SEC-promulgated antifraud rules and regulations under Exchange Act);Exchange Act Rule 1Ob-3, 17 C.F.R. § 240. lOb-3 (1994) (prohibiting fraud in sale of securi-ties by registered broker-dealers); id. § 240.1Ob-5 (prohibiting fraud in sale of securities gen-erally).

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1458 52 WASH. & LEE L. REV 1441 (1995)

meet the definition of "securities" in the federal securities laws. I4 The fed-eral securities laws delegate the power to enforce violations of the antifraudprovisions to the SEC.15 The CFTC regulates dealers to the extent thatdealers offer and sell futures contracts and options on futures contracts, in-cluding some types of swaps, and dealers that qualify as commodity tradingadvisors.11 6 The CFTC promulgated a regulation exempting certain swapagreements and participants in certain swap agreements from all the pro-visions, except the antifraud provisions, 11 7 of the CEA. "8 Thus, derivativesdealers that sell or recommend transactions that meet the defimtion of futurescontracts or options on futures contracts, including certain types of swapagreements, face liability under the antifraud provisions of the CEA.

Until the BT Securities Corporation (BT Securities) settlements, whichthe SEC and CFTC announced on December 22, 1994,19 the federal regula-tory agencies had not determined to what extent, if any, the federal securitieslaws and the CEA applied to OTC derivatives trading activities. The CFTCand the SEC announced a joint settlement with BT Securities related to BT

114. See Securities Exchange Act of 1934 § 15, 15 U.S.C. § 78o (1988 & Supp. V 1993)(providing that SEC shall regulate securities market participants).

115. See Securities Act of 1933 § 8A, 15. U.S.C. § 77h-1 (Supp. V 1993) (providing thatSEC may institute administrative proceedings to enforce antifraud provisions); Securities Ex-change Act of 1934 §§ 21, 21C, 15 U.S.C. §§ 78u, 78u-i (1988) (same); id. at § 78o(b)(4)(granting SEC ability to limit activities of, suspend registration of, or revoke registration of reg-istered dealers that willfully violate federal security and commodity laws).

116. See Commodity Exchange Act, 7 U.S.C. §§ la, 2 (1988 & Supp. V 1993) (providingthat CFTC shall exclusively regulate participants in commodity futures markets and defimng"commodity exchange advisor"). A commodity trading advisor is a person who, for compensa-tion or profit, advises others about the value of commodities futures contracts, or recommendsspecific transactions. See id. at § la (defining "commodity trading advisor").

117 See Commodity Exchange Act §§ 4b, 4o, 7 U.S.C. §§ 6b, 6o (1988 & Supp. V 1993)(forbidding fraud in the sale of commodities futures); 17 C.F.R. § 32.9 (1994) (same). TheCommodity Exchange Act (CEA) § 4b applies to all dealers, while § 4o applies only to com-modity trading advisors and "commodity pool operators." Compare Commodity Exchange Act§ 4b with Commodity Exchange Act § 4o. The CFTC may seek to enjoin or restrain violationsof the CEA's antifraud provisions in federal court. See Commodity Exchange Act § 6(c), 7U.S.C. § 13a-1 (1988 & Supp. V 1993) (providing that CFTC may initiate proceedings to enjoinor restrain violations of CEA in federal court). The CEA makes all violations of commoditieslaws felonies punishable by fines up to $1 million. See id. at § 9(a)(2), 7 U.S.C. § 13(a)(2)(classifying violations of CEA as felomes and providing for punishments).

118. See 17 C.F.R. § 35.2 (1994) (exempting certain swap agreements and participants inswap agreements from all provisions of CEA except antifraud provisions).

119. BT Securities Corp., Securities Act Release No. 7,124, Exchange Act Release No.35,136, [1994 Transfer Binder] Fed. See. L. Rep. (CCII) 85,477 (Dec. 22, 1994) [hereinafterBTSecurities, SEC]; BT Securities Corp., 1994 CFTC LEXIS 340 (Dec. 22, 1994) [hereinafterBT Securities, CFTC].

SUITABILITYREQUIREMENTS

Securities's offer and sale of complex counterparty OTC derivatives to Gib-son Greetings, Inc. (Gibson).1'2 Bankers Trust Corporation (Bankers Trust),a New York banking corporation, was the counterparty to each derivativeinstrument that BT Securities sold to Gibson. 12 Bankers Trust New YorkCorporation (BTNY), a publicly-traded bank holding company, owned allof the outstanding stock of both Bankers Trust and BT Securities.' "

In May 1991, Gibson issued $50 million in notes with an interest rateof 9.33 %. " After the issuance of the notes, interest rates declined! 4 Be-cause Gibson could not prepay the notes for a number of years, Gibson con-sidered engaging in interest rate swaps to effectively reduce the interest rateon the notes."z Gibson entered into a series of nearly thirty counterpartyderivatives transactions, including amendments to existing derivative mstru-ments, with BT Securities from November 1991 to March 1994." Overtime, the derivatives that BT Securities sold to Gibson became increasinglycomplex, risky, and intertwined. 7 Many of the derivatives had leveragefactors that caused Gibson's losses to increase dramatically in relation torelatively small fluctuations in interest rates."2 Each of the derivative instru-ments that BT Securities sold to Gibson was a customized OTC counterpartyagreement and did not trade on any market.129

In the SEC's settlement with BT Securities, the SEC based its jurisdic-tional claim on the finding that certain counterparty derivatives transactionsbetween BT Securities and Gibson were "securities" within the meaning ofthe federal securities laws."3 Specifically, the "Treasury-Linked Swap"" 1

120. See BTSecurities, SEC, supra note 119; BTSecurities, CFTC, supra note 119.121. BT Securities, SEC, supra note 119, at 2; BT Securities, CFTC, supra note 119, at 2.122. TSecurities, SEC, supra note 119, at 2; BT Securities, CFTC, supra note 119, at 2.123. BTSecurities, SEC, supra note 119, at 3; BT Securities, CFTC, supra note 119, at 3.124. STSecurities, SEC, supra note 119, at 3; BTSecurities, C7C, supra note 119, at 3.

125. STSecurities, SEC, supra note 119, at 3; BT Securities, CFTC, supra note 119, at 3.126. STSecurities, SEC, supra note 119, at 3; BT Securities, CFTC, supra note 119, at 3.127 BTSecurities, SEC, supra note 119, at 3; BTSecurities, CFTC, supra note 119, at 3.128. BTSecurities, SEC, supra note 119, at 3; BT Securities, CFTC, supra note 119, at 3.129. BTSecurities, SEC, supra note 119, at 3; BTSecurities, CFTC, supra note 119, at 3.130. See BT Securities, SEC, supra note 119, at 11 (observing that because certain

denvative instruments sold by BT Securities to Gibson fell within definition of "securities" underfederal securities laws, federal securities antifraud provisions applied to transactions).

131. The terms of the "Treasury-Linked Swap" required Gibson to periodically pay toBankers Trust (the counterparty) the London Interbank Offered Rate (LIBOR) on the $30 million(the notional amount). BT Securities, SEC, supra note 119, at 7 In return, Bankers Trustwould make periodic payments to Gibson equal to LIBOR plus 200 basis points on $30 million.Id. At maturity, Gibson would pay Bankers Trust $30 million; Bankers Trust would pay Gibson

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and the "Knock-Out Call Option,"132 together with their amendments, quali-fied as securities. 33 The SEC observed that the Treasury-Linked Swap, al-though labeled a swap, was actually an option on a security " Accord-ingly, the SEC ruled that the Treasury-Linked Swap fell within the federalsecurities laws' defimtion of "security "'I' Likewise, the SEC found thatthe Knock-Out Call Option was an option on a security and thus a "securi-ty" for the purposes of the federal securities laws.' 36

Because certain transactions between BT Securities and Gibson fellwithin the defintion of securities in the federal securities laws, the anti-fraud provisions of the federal securities laws applied to the transactions.' 37

The SEC found that BT Securities had engaged in material misrepresen-tations and omssions in BT Securities's offer and sale of the Treasury-Linked Swap and the Knock-Out Call Option, together with their amend-

the lesser of $30.6 million or an amount equal to:

103 x 2-yr. Treasury yld.$30M 1 - .88%- 30-yr. Treasury price

$ 30M x I -4 . 810 100

Id.

132. The "Knock-Out Call Option" was, in simplest terms, an option contract. BTSecurities, SEC, supra note 119, at 8 n.7 BT Securities sold the Knock-Out Call Option toGibson for a fee, or an option premium. See id. at 9 (referring to transactional fees chargedto Gibson for entering into Knock-Out Call Option). The terms of the Knock-Out Call Optionrequired Bankers Trust (the counterparty) to pay Gibson, on the settlement date, an amountequal to:

(6.876% - Yield at Maturity of 30-year U.S. Treasury security) x 12.5 x $25,000,000.

Id. at 8. However, if at any time during the life of the Knock-Out Call Option the yieldon the 30-year U.S. Treasury security dropped below 6.48%, the option expired - orwas "knocked out" - and became worthless. Id. In addition, the Knock-Out Call Optionwas not "exercisable" until the settlement date. Id. BT Securities marketed the Knock-OutCall Option as a hedging strategy to reduce the market risk of the Treasury-Linked Swap.Id. Specifically, the value of the Knock-Out Call Option would rise as the value of theTreasury-Linked Swap fell, and vice versa. See id. at 7, 8 (providing terms of Treasury-Linked Swap and Knock-Out Call Option, which show inverse relationship betweeninstruments).

133. See rd. at 6 n.6, 7, 8 & n.7 (determining that Treasury-Linked Swap and Knock-OutCall Option, together with amendments, were securities within meaning of federal securitieslaws).

134. Id.135. Id. at 7136. Id. at 8 & n.7, 9

137 Id. at 11.

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SUITAB1ITYREQUIREMENTS

ments.131 Accordingly, the SEC determined that BT Securities violated

Section 17(a) of the Securities Act, 139 Section 10(b) of the Exchange Act, 140

and Exchange Act Rule 10b-5' 41 when BT Securities entered into the trans-

actions. 142

The SEC cited several specific incidents of misrepresentation.'43 Forexample, when Gibson asked BT Securities for valuations of Gibson'sderivative positions, BT Securities provided valuations that significantlyunderstated Gibson's losses.'" In addition, the SEC found that BTSecurities had omitted material valuation information when BT Securitiesproposed new transactions or amendments to existing transactions."4 ' BTSecurities also provided false valuations of Gibson's derivatives positionswhen Gibson asked BT Securities to provide valuations for use in prepanngGibson's year-end financial statements."' Gibson, relying on the falsevaluations, filed financial statements that materially understated Gibson'slosses from derivatives activities. 47 Accordingly, the SEC found that BTSecurities caused violations of Section 13(a) of the Exchange Act14' and

138. Id.

139. Securities Act of 1933 § 17(a), 15 U.S.C. § 77q(a) (1988).140. Securities Exchange Act of 1934 § 10(b), 15 U.S.C. § 78j(b) (1988).

141. 17 C.F.R. § 240.10b-5 (1994).142. BT Securities, SEC, supra note 119, at 11.

143. See id. at 4-9 (citing specific incidents of BT Securities's fraudulent conduct).

144. Id. at 4-6. The SEC opinion included transcripts of telephone conversations be-tween BT Securities employees. Id. at 4-5. In one conversation, a BT Securities employeeadvised another about how to hide misstatements made to Gibson:

I think that we should use this [downward market pnce movement] as an opportunity.We should just call [the Gibson contract], and maybe clup away at the differential alittle more. I mean we told lum $8.1 million when the real number was 14. So nowif the real number is 16, we'll tell him that it is 11. You know, just slowly chip awayat that differential between what it really is and what we're telling him.

Id.

145. See id. at 7, 9 (observing that BT Securities omitted relevant information concern-ing Gibson's derivatives positions as well as transaction costs and opportunity costs associatedwith entering into new agreements or amendments to existing agreements). In short, BTSecurities repeatedly failed to disclose adequately to Gibson how a proposed agreement oramendment would affect Gibson's overall position in terms of unrealized gains, fees, andrisks. Id.

146. See id. at 5-6 (describing Gibson's requests to BT Securities for valuations ofGibson's derivatives positions to assist Gibson in preparing year-end financial reports anddescribing BT Securities's quotatuon of false values).

147 Id. at 10-11.

148. Securities Exchange Act of 1934 § 13(a), 15 U.S.C. § 78m(a) (1988).

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Exchange Act Rules 13a-1149 and 12b-20 5 ' when Gibson filed the mislead-ing financial statements.151

The SEC observed that the derivatives that BT Securities sold to Gib-son were so complex that sophisticated computer models were the onlymeans of valuation, and, moreover, that Gibson depended solely on BTSecurities to value Gibson's positions.152 Furthermore, the opinion clearlyindicated that Gibson relied heavily on the advice of BT Securities con-cering the suitability of the derivatives transactions. 15' However, SECofficials emphasized that the BT Securities enforcement action involvedonly fraud, not suitability or sales practice.' 54

The same day that the SEC announced the BT Securities settlement,the SEC issued a release exempting dealers of certain OTC derivativeinstruments, to the extent that such instruments fall within the definition of"securities" under the federal securities laws, from Section 15(a) theExchange Act, 155 which requires securities dealers to register with theSEC.'56 Specifically, the exemption applies to any dealer that engages inindividually negotiated, cash-settled OTC options on debt securities, orgroups, or indexes of debt securities. The exemption, however, coversonly transactions that participants document as "swaps" and that qualify forexemption under the CEA. 157 The SEC issued the exemption in an effort

149 17 C.F.R. § 240.13a-1 (1994).150. 17 C.F.R. § 240.12b-20 (1994).151. BTSecurities, SEC, supra note 119, at 11.152. Id. at 3-4.153. See id. at 7-9 (observing that Gibson entered into every amendment to its Treasury-

Linked Swap and Knock-Out Call Option agreements that BT Securities proposed over eightmonth period).

154. See SEC News Release 94-180, at 1 (Dec. 22, 1994) (quoting remarks made byWilliam R. McLucas, SEC Director of Enforcement, to effect that BT Securities case wasfraud, not suitability case). The BT Securities case did not attempt to address the issue ofsuitability or sales practice apart from enforcing antifraud provisions of the federal securitieslaws. Interview with Howard Kramer, SEC Associate Director, Division of Market Regula-tion, in Washington, D.C. (Jan. 20, 1995).

155. See Securities Exchange Act of 1934 § 15(a), 15 U.S.C. § 78o(a) (1988) (forbiddingoffer or sale of securities by unregistered dealers).

156. See Order Exempting Certain Brokers and Dealers From Broker-Dealer Registra-tion, Exchange Act Release No. 35,135, Fed. Sec. L. Rep. (CCH) 85,476 (Dec. 22, 1994)(exempting dealers of certain derivative instruments, to extent that such instruments are"securities," from registration requirement under § 15(a) of Exchange Act). The exemptionis temporary and will expire September 30, 1995. Id. at 5.

157 Id. at 5-6.

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SUITABILITYREQUIREMENTS

to avoid the possibility of a "short term dislocation" of existing OTC denv-atives markets that might arise due to legal uncertainty in the wake of theBT Securities settlement. 58 The exemption, however, allows existingunregistered dealers of certain derivatives to avoid being subject to NASD-promulgated sales practice and suitability regulations. 5 9

The CFTC, in its settlement with BT Securities, based its jurisdictionon a determination that BT Securities qualified as a "commodity tradingadvisor" under the CEA160 with respect to its derivatives transactions withGibson.161 Specifically, the CFTC deternuned that BT Securities had ac-knowledged that it had entered into an advisory relationship with Gibsonand thereby qualified as a commodity trading advisor under the CEA. 62

The CFTC found that BT Securities, as a commodity trading advisor, vio-lated Section 4o(1)(A) of the CEA63 by defrauding Gibson."

The joint settlement with BT Securities established that the SEC andthe CFTC have jurisdiction over many types of OTC swap agreements. Al-though the agencies have exempted the dealers in such swap agreements

158. See id. at 4, 5 n.3 (explaining that reason for exemption of OTC dealers is toprevent dislocation of OTC derivatives markets due to legal uncertainty). The SEC release,however, warned that the SEC did not intend the exemption to permit registered dealersconducting certain derivatives transactions to move their derivatives activities to unregisteredaffiliates. Id. at 5 n.3.

159. See Securities Exchange Act of 1934 § 15A, 15 U.S.C. § 78o-3 (1988) (limitingjurisdiction of NASD to registered dealers).

160. See Commodity Exchange Act § la(5), 7 U.S.C. § la(5) (Supp. V 1993) (defining"commodity trading advisor").

161. BT Securities, CFTC, supra note 119, at 15-16; see also infra notes 117-18 andaccompanying text (explaining CFTC's jurisdiction over swap agreements and explainingeffect of exemption for swap agreements).

162. BT Securities, CFTC, supra note 119, at 15-16. The CFTC relied on two state-ments that BT Securities employees made about Gibson in determining that an advisoryrelationship existed between BT Securities and Gibson. Id. at 15. In February 1994, BTSecurities's managing director for the Gibson account told his supervisor that, "from the verybeginning, [Gibson] just, you know, really put themselves in our hands like 96 % Andwe have known that from day one." Id. at 15. The managing director also remarked that"these guys [Gibson] have done some pretty wild stuff. And you know, they probably do notunderstand it quite as well as they should. I think that they have a pretty good understandingof it, but not perfect. And that's like perfect for us." Id.

163. 7 U.S.C. § 6o(1)(A) (1988 & Supp. V 1993). The CFTC, however, did not findthat BT Securities had violated CEA § 4b, 7 U.S.C. § 6b (1988 & Supp. V 1993). TheCFTC would not have had to determine that BT Securities qualified as a commodity tradingadvisor if the CFrC had relied on § 4b. See supra note 117 (comparing CEA §§ 4b and 4o).

164. BT Securities, CFTC, supra note 119, at 16.

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from most commodities and securities laws, the antifraud provisions of theCEA and the federal securities laws apply to these transactions. Therefore,dealers in such transactions must provide accurate and adequate informationto customers or face liability under these antifraud provisions.

2. Regulation of Derivatives Dealers by FinancialInstitution Regulators

Four different federal regulators oversee federally insured bankinginstitutions and their derivatives practices, both as dealers and as end-users."'65 The Office of the Comptroller of the Currency (OCC) regulatesnationally chartered banks.1 66 The Federal Reserve Board oversees statechartered banks that are members of the Federal Reserve, and bank holdingcompanies. 67 The FDIC regulates state chartered banks that are not mem-bers of the Federal Reserve and, in addition, has some supervisory respon-sibilities for all federally insured depository institutions. 6' The Office ofThrift Supervision (OTS) oversees both state chartered and federallychartered thrifts. 69 Neither the FDIC nor the OTS have promulgated suita-bility requirements.

Banking Circular 277 (Circular 277), 70 released by the OCC in Octo-ber 1993, lays out specific directives to national banks concerning the riskmanagement of derivatives. Circular 277 contains descriptions of the risksthat are present in derivatives transactions and advice on how to identifyand manage these risks effectively '.. When discussing credit risk man-agement, Circular 277 directs bank credit officials that are responsible forestablishing and supervising the derivatives credit lines of customers toinclude an analysis of the impact of a proposed derivatives transaction on

165. Suitability requirements imposed by state bank regulators are beyond the scope ofthis Note.

166. See 12 U.S.C. § 24 (Seventh) (1988 & Supp. V 1993) (providing that Comptrollerof Currency shall regulate securities practices of nationally chartered banks).

167 See id. at § 1818 (providing that Federal Reserve Board shall govern securitiespractices of banks that are members of Federal Reserve).

168. See id. at § 1818(a)(2)(A)(i) (providing that FDIC may suspend insurance of anyinsured bank that engages in "unsafe or unsound practices").

169 See id. at § 1464(c) (providing that Director of Office of Thrift Supervision shallregulate investment and securities practices of thrifts).

170. COMPTROLLER OF THE CURRENCY, BANKING CIRCULAR 277 (Oct. 27, 1993)repnnted in Fed. Banking L. Rep. (CCH) 58,717, at 36,459 [hereinafter CIRCULAR 277].

171. Id.

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SU1TABIL1TYREQUIREMENTS

the financial condition of a customer in determining the creditworthiness ofthe customer and to ensure the full realization of credit risk factors.17 2

Circular 277 also requires bank officials to assess the applicability ofproposed derivatives transactions to the customer's financial goals.1 73 Cir-cular 277 further provides that when bank officials believe that a proposedderivatives transaction may not be "appropriate" for a customer, bankofficials should inform the customer of this fact."7 In such a case, the bankmay follow the customer's wishes to proceed only if the bank documentsboth its analysis of the transaction and the information that the bank pro-vided to the customer. 175

The OCC demes that Circular 277 imposes a suitability standardon bank derivatives dealers. 7 6 Instead, the OCC contends that Circular277 merely serves to ensure that banks evaluate the credit risks involvedin derivatives transactions using the same principles that banks use innondenvatives transactions. 77 The OCC emphasizes that Circular 277

172. See id. at 36,462 (charging bank credit officers to understand impact of proposedderivatives transaction on customer's financial condition).

173. See id. (directing bank credit officers responsible for derivatives credit lines tounderstand applicability of proposed derivatives transaction to risks that customer seeks tomanage).

174. See id. (directing bank to document both analysis that particular derivativestransaction is inappropriate and information that bank provides to customer); see also COMP-TROLLER OF THE CURRENCY, QUESTIONS AND ANSWERS FOR BC-277" RISK MANAGEMENT OF

FINANCIAL DERIvATiVES (OCC 94-31) (May 10, 1994), repnnted in Fed. Banking L. Rep.(CCH) 58,717, at 36,473, 36,479 [hereinafter Q&A] (instructing bank that determines thatderivatives transaction is inappropriate for customer to document discussions held with cus-tomer concerning appropriateness).

175. See CIRCULAR 277, supra note 170, at 36,462 (permitting bank to proceed with"inappropriate" derivatives transaction if bank documents analysis of transaction and warningto customer).

176. See Q&A, supra note 174, at 36,478-79 (denying that CIRCULAR 277 imposessuitability standard on bank derivatives dealers); Telephone Interview with Michael L. Bros-nan, National Bank Examiner, Capital Markets, Office of the Comptroller of the Currency(Feb. 7, 1995) (same).

177 See Q&A, supra note 174, at 36,478-79 (observing that customer's ability toperform obligations under derivatives transactions depends, m part, on appropriateness oftransaction). Proper credit analysis requires that banks know about their customers' busi-nesses. Telephone Interview with Michael L. Brosnan, National Bank Examiner, CapitalMarkets, Office of the Comptroller of the Currency (Feb. 7, 1995). The OCC compares acustomer's ability to perform the obligations of a derivatives transaction to a borrower'sability to repay a loan. Id. The OCC also notes that documenting both a bank's analysis ofa derivatives transaction's appropriateness and the concerns voiced to customers about map-propriateness would likely aid a bank in the event that a bank-sponsored derivatives trans-

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does not prohibit banks from selling derivatives to unsophisticated cus-tomers. 1 s

A Federal Reserve Board "SR Letter" entitled Examining Risk Man-agement and Internal Controls for Trading Activities of Banking Organiza-tions (SR Letter) contains the Federal Reserve Board's policy concerningderivatives transactions with unsophisticated customers." 9 Like Circular277, the SR Letter requires banks to consider a derivatives customer'ssophistication in the determination of credit risk.8 However, in contrastwith Circular 277, the SR Letter also discusses business practices.' TheSR Letter advises banks dealing with "unsophisticated" derivatives custom-ers to ensure that such customers are aware of the particular risks of eachproposed derivatives transaction.' The SR Letter, however, notes thatcustomers are ultimately responsible for the transactions that they chooseto undertake. 8 3

On December 5, 1994, the Federal Reserve Bank of New York enteredinto a written agreement (Agreement) concerning sales practice and suita-bility of leveraged derivatives transactions (LDTs) with Bankers Trust NewYork Corporation and its subsidiaries (collectively BTNY), including BTSecurities. 4 In the Agreement, BTNY agreed to ensure reasonably thateach LDT customer "has the capability to understand" the elements of any

action turns out to be "unprofitable." Id. In such a case, documentation might help exculpatethe bank in litigation and exonerate the bank m the minds of the public. Id.

178. See Q&A, supra note 174, at 36,479 (stating that CIRCULAR 277 does not prohibitbank from executing inappropriate derivatives transaction).

179 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, EXAMINING RISK

MANAGEMENT AND INTERNAL CONTROLS FOR TRADING ACTIVITIES OF BANKING ORGANIZA-

TIONS (SR 93-69) (Dec. 20, 1993), reprnted in Fed. Banking L. Rep. (CCH) 58,717, at36,467 [hereinafter SR LETTER].

180. See id. at 36,470 (directing banks to consider customer's ability to understand andmanage risks inherent in derivatives transaction in assessing credit risk).

181. Compare id. at 36,472 (discussing business practices with respect to deriva-tives transactions) with CIRCULAR 277, supra note 170, at 36,459 (omitting any mentionof business practices concerning derivatives transactions apart from internal risk manage-ment).

182. See SR LETTER, supra note 179, at 36,472 (defining "sound business practices" toinclude ensuring that unsophisticated derivatives customers are aware of risks of each deriva-tives transaction). The Federal Reserve notes that customers may be unsophisticated eithergenerally or with respect to a particular type of transaction. Id.

183. Id.184. WRITTEN AGREEMENT BY AND AMONG BANKERS TRUST NEW YORK CORP.,

BANKERS TRUST Co., BT SECURITIES CORP., AND FEDERAL RESERVE BANK OF NEW YORK

(Dec. 5, 1994) [hereinafter FEDERAL RESERVE AGREEMENT].

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LDT that a customer undertakes."' 5 Furthermore, BTNY agreed to provideeach customer with sufficient information to allow the customer to under-stand the transaction.1 16

Specifically, the Agreement requires BT to develop written policiesand procedures designed to ensure reasonably that each LDT customerunderstands any LDT that a customer undertakes.1 17 The policies and pro-cedures must provide for disclosure of the basic nature, material terms,conditions, and risks of proposed LDTs."'8 In addition, these policies andprocedures must provide for the distribution of "term sheets" and "sensitiv-ity analyses" to customers at the closing of every LDT and upon customerrequest.8 9

B. A Summary of the GAO Report's Recommendations ConcerningRegulation of OTC Derivatives Dealers

The GAO Report concluded that present OTC derivatives, tradingpractices pose a threat to the global financial system. 1"° In particular, theGAO Report cautioned that because a few major dealers dominate the OTCderivatives market,' 9' and because OTC derivatives trading has expandedlinkages among the dealers and end-users and the markets m which thedealers and end-users trade,' 2 a failure of one of the major dealers couldcause liquidity problems in the markets, which could, in turn, set off aglobal financial crisis.193 In addition, the GAO Report observed that theFDIC insures many of the major OTC derivatives dealers and that a-chain

185. Id. In addition, BTNY agreed to develop and submit to the Federal Reserve Bankof New York written policies and procedures designed to ensure reasonably that each LDTcustomer has the capability to understand all the elements of any LDT a customer undertakes.Id.

186. Id. In addition, BTNY agreed to develop and submit to the Federal Reserve Bankof New York written policies and procedures designed to ensure reasonably that BTNY dis-closes to each LDT customer sufficient information to allow the customer to understand allthe elements of any LDT that BTNY enters into with the customer. Id.

187 Id.188. Id.189. Id.190. See GAO REPORT, supra note 16, at 9-14 (summarizing findings that regulatory

gaps in OTC derivatives trading heighten risk of systemic collapse).191. Id. at 36-37192. Id. at 37-39.193. Id. at 107, 123.

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reaction of failures could require a federal bailout far exceeding the savingsand loan disaster. 94

Although the GAO Report concentrated on bank safety and soundnessconcerns, deficiencies in risk management, and systemic risk, the GAOReport also observed that no government agency regulates many OTCderivatives dealers and expressed alarm over this regulatory "gap." 195 TheGAO Report also noted that each of the five major securities firms thatacted as derivatives dealers in 1993 conducted their derivatives activitiesthrough one or more unregistered affiliates.' 96 According to SEC officials,the treatment of OTC derivatives under the SEC's capital requirement pro-visions has influenced registered dealers to conduct derivatives activitiesthrough unregistered affiliates."9

The GAO Report urged Congress to bring the unregulated OTC de-rivatives dealers under the oversight of federal regulators to ensure thatderivatives regulation is comprehensive.998 The GAO Report suggested twosolutions: (1) expand the jurisdiction of the SEC to include all OTC deriva-

194. Id. at 124-25.195. See id. at 86-87 (observing that neither SEC nor CFTC directly regulates activities

of OTC derivatives dealers that are not either registered dealers or futures commission mer-chants).

196. See id. at 87 (observing that each registered securities dealer m survey con-ducted derivatives activities m one or more unregistered and, thus, unregulated affiliates).

197 See id. at 88-89 (explaining reasons securities dealers use unregistered affiliatesto offer and sell derivatives). The GAO Report observed that the SEC uses the net capitalrule to oversee the financial soundness of registered dealers. Id. at 88. The net capital ruleprovides that no dealer shall permit the dealer's aggregate indebtedness to eRceed 15 timesthe dealer's net capital. 17 C.F.R. § 240.15c3-1(a)(1)(ii) (1994). The rule allows a dealerto include the value of all the assets, including securities, held by the. dealer in calculatingthe dealer's net capital. Id. § 240.15c3-1(c)(2). Under the rule, however, a dealer mustdiscount the value of the assets, including securities, held by the dealer by various amounts(called "haircuts") depending on the liquidity and riskiness of the assets. GAO REPORT,

supra note 16, at 88. In applying the net capital rule to swaps, registered dealers are to addto their net worth the value of any swaps with unrealized positive market value and subtractfrom their net worth the value of any contracts with a negative market value. Id. Inaddition, however, dealers must deduct from their net worth calculation, the value of anyswap payments due to them as unsecured receivables. Id. at 89. Dealers must furtherreduce any swap with a positive market value by up to 6% of the notional amount of thecontract, depending on the term of the swap and whether the dealer has offset or hedgedthe swap. Id. The net capital rule also requires dealers to subtract various percentages ofthe market value of other derivatives when calculating net capital. Id. Therefore, deriva-tives can tie up large portions of a registered dealer's capital. Id.

198. GAO Report, supra note 16, at 127

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tives dealers199 and (2) divide responsibility for regulating OTC derivativesdealers among the various securities, commodities, and financial regulatorson the basis of each agency's expertise and mission.2°

C. Proposed Legislation Affecting Suitability Requirements forOTC Derivatives Dealers

Of all the legislation governing derivatives that legislators introducedin 1994 and 1995, only one bill, House Bill 4745 (HB 4745), endeavoredto fill the perceived gap in the regulation of OTC derivatives dealers."' Inits most basic terms, HB 4745 would amend the Exchange Act to includederivatives within the definition of "securities."20 2 HB 4745 would encom-pass virtually all OTC derivatives dealers because the legislation broadlydefines "derivative. 20 3 The bill would require every OTC derivativesdealer to either (1) register with the SEC as a securities dealer if theparticipant is not affiliated with a registered securities dealer or (2) notifythe SEC in writing that the participant is a derivatives dealer if theparticipant is "materially associated" with a registered securities dealer.204

HB 4745 would subject all dealers that must register with, or notify,the SEC of derivatives activity to all the provisions of the federal securitieslaws, including the antifraud provisions. 2' The bill also would expressly

199. Id.200. Id.

201. Compare H.R. 4745, 103d Cong., 2d Sess. § 201 (1994) (providing that SECshall have jurisdiction over OTC derivatives dealers) with H.R. 31, 104th Cong., 1st Sess.(1995) (pertaining only to financial institutions) and H.R. 20, 104th Cong., 1st Sess. (1995)(same) and S. 2291, 103d Cong., 2d Sess. (1994) (same) and H.R. 4503, 103d Cong., 2dSess. (1994) (same) and S. 2123, 103d Cong., 2d Sess. (1994) (same) and H.R. 4170, 103dCong., 2d Sess. (1994) (same) and H.R. 3748, 103d Cong., 2d Sess. (1994) (same).

202. See H.R. 4745, 103d Cong., 2d Sess. § 201 (1994) (amending definition of"securities" in Securities Exchange Act § 3(10) to include "derivatives").

203. See id. § 2 (defining derivative to include any instrument that derives its valuefrom value or performance of any security, currency exchange rate, or interest rate).

204. See id. § 101 (prohibiting sale of derivatives by unregistered dealers unless dealeris "materially associated" with another registered dealer and has notified SEC of derivativesactivity). HB 4745 would require not only derivatives dealers to register with the SEC, butthe bill also would require any entity that buys, sells, or enters into OTC derivative instru-ments for that entity's own account to register. Id. HB 4745, however, would allow theSEC to unconditionally exempt any derivatives market participant or class of participantsfrom the registration requirement. Id.

205. See id. (subjecting dealers willfully violating any provision of federal securitieslaws to suspension or revocation hearings under § 15(b)(4) of Exchange Act).

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delegate to the SEC the authority to promulgate additional rules and regula-tions designed to prevent fraudulent, deceptive, or manipulative acts in de-rivatives transactions.' In addition, HB 4745 would require all derivativesdealers that are required to register with the SEC also to register with theNASD 207 This registration requirement would subject such dealers to theNASD's rules, including sales practice requirements. 28

IV An Analysis of OTC Derivatives Dealer Suitability Requirements

All sides agree that derivatives are useful and important to the econ-omy 209 Commentators and regulators have repeatedly warned againstenacting inappropriate initiatives designed to regulate derivatives.210 TheGAO Report itself acknowledged that unilateral regulatory action by theUnited States could hamper American firms' competitiveness and encour-age these firms to move their derivatives activities off-shore."'

The GAO Report expressed concern over the gap in regulation ofunregistered OTC derivatives dealers.212 The SEC, however, preserved thegap in December 1994 by exempting unregistered dealers that engage incertain derivatives transactions from SEC registration to the extent that the

206. Id.207 See id. (requiring every derivatives dealer to register with securities association).

Currently, the NASD is the only such securities association. The bill, however, would allowthe SEC to unconditionally exempt any derivatives dealer or class of derivatives dealers fromthe securities association registration requirement. Id.

208. See supra notes 102-09 and accompanying text (explaining NASD's rules regardingsales practice).

209 See GAO REPORT, supra note 16, at 123 (describing derivatives as important toglobal financial marketplace); GROUP OF THIRTY, supra note 62, at 63 (enumerating benefitsof financial innovation); Culp & Mackay, supra note 41, at 39-40 (describing benefits of OTCderivatives to end-users and dealers).

210. See Derivatives Market: Hearings Before the Senate Comm. on Bankng, Housingand Urban Affairs, 104th Cong., 1st Sess. (1995) (statement of Alan Greenspan, Chairman,Federal Reserve Board) (warning that singling out derivatives for special regulatory treatmentwould be "serious mistake"); Culp & Mackay, supra note 41, at 48 (proposing new type ofrisk inherent in derivatives - "regulatory risk"); Thomas C. Theobald, Regulatory Choke-hold: Derivatives Aren't the Danger, WALL ST. J., May 23, 1994, at A14 (arguing that mar-ket forces will provide more efficient oversight of derivatives than new government regula-tion).

211. GAO REPORT, supra note 16, at 107 (warning that excessive regulation will drivederivatives activities overseas); see also Culp & Mackay, supra note 41, at 50 (same).

212. See supra notes 195-97 and accompanying text (describing GAO Report's concernover unregulated OTC derivatives dealers).

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dealers offer and sell securities.213 The SEC recogmzed that forcingpreviously unregulated derivatives dealers to register with the SEC and thussubjecting these dealers to stringent capital, reporting, and sales practicerequirements, nught result in a "dislocation" of existing OTC derivativesmarkets.214 The Group of Thirty's survey also played down the need toclose the gap in regulation.215

Regulators impose suitability requirements on dealers for two principalreasons:2 16 (1) to reduce dealers' credit risk exposure 217 and (2) to protectunsoplusticated customers. 1 First, suitability requirements reduce dealers'credit risk exposure by forcing dealers to include an evaluation of thesuitability of a proposed derivatives transaction in assessing the credit-worthiness of prospective derivatives counterparties.2 1 9 Second, suitabilityrequirements protect unsophisticated customers by forcing dealers to assessthe appropriateness of derivatives transactions that dealers undertake withcustomers.' The credit risk exposure of derivatives dealers concerns bankregulators more than securities and commodities regulators.221 Both bank

213. See supra notes 155-59 and accompanying text (describing SEC's order exemptingcertain swaps dealers from SEC's registration requirement).

214. See Order Exempting Certain Brokers and Dealers From Broker-Dealer Registra-tion, supra note 156, at 5 n.3 (explaining that SEC issued exemption to avoid dislocation ofcurrent OTC derivatives markets); cf. Municipal Bond and Government Securities Markets:Hearngs Before the Senate Comm. on Banking, Housing and Urban Affairs, 104th Cong.,1st Sess. (1995) (prepared testimony of Arthur Levitt, Chairman, Securities and ExchangeCommission) (stating that SEC staff will analyze how rules regarding capital requirementsand sales practice apply to OTC derivatives markets m preparation for expiration of exemp-tion).

215. See GROUP OF TEIRTY, supra note 62, at 63 (observing that unregulated derivativesdealers have promoted competition and innovation without any evidence of increased systemicrisk).

216. Regulators also impose suitability requirements to protect the reputations of theentities they regulate. See supra note 177 (describing effects of suitability requirements onreputation of bank). Suitability requirements protect dealers' reputations by ensuring thatdealers act fairly when dealing with unsophisticated counterparties. See id.

217 See supra note 177 and accompanying text (explaining that appropriateness require-ment in Circular 277 reduces credit risk).

218. See supra notes 103-05 (explaining how NASD's RFP seek to protect unsophisti-cated customers).

219. See supra note 177 and accompanying text (explaining that Circular 277"s appropri-ateness requirement is designed to reduce unperceived credit risks of banks).

220. See supra notes 103-05 and accompanying text (describing NASD's suitability stan-dard).

221. Compare CIRCULAR 277, supra note 170 and SR LETTER, supra note 179 (both

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regulators and securities regulators, however, seek to protect unsophisti-cated customers. 222 Because experts generally agree that regulation offederally insured banks' credit risk exposure is necessary, if not beneficial,the remainder of this Note will evaluate suitability requirements designedto protect unsophisticated customers.

Suitability provisions alter the traditional arms-length relationshipbetween buyers and sellers by requiring derivatives dealers to protect theircustomers' interests. 3 Markets function most efficiently when parties toa financial transaction are free to enter into the transaction unhampered bya perceived need to serve the interests of their counterpartes.224 Suitabilityrequirements would increase transaction costs in the derivatives market.

Relationships between buyers and sellers in the derivatives market,however, can differ from such relationships in other markets. Denva-tives dealers often advise clients and recommend specific transactions.mIn an advisory relationship, a dealer's profit motive conflicts with the

stating that appropriateness requirements serve to reduce bank credit risk exposures) withRFP, supra note 103, at art. HI, § 2 (imposing suitability requirement, but not to reducedealer credit risk exposure).

222. See supra notes 184-89 and accompanying text (explaining that Federal Reserve'sWritten Agreement with BTNY sought to protect prospective derivatives customers); supranotes 103-05 and accompanying text (explaining how, NASD's RFP seeks to protectcustomers).

223. See DERIVATIVES POLICY GROUP, FRAMEWORK FOR VOLUNTARY OVERSIGHT 37(1995) (stating that OTC derivatives transactions are predominantly arm's-length in nature);Memorandum from the Drafting Committee of PRINCIPLES AND PRACTICES FOR WHOLESALEFINANCIAL MARKET TRANSACTIONS 7-8 (Aug. 17, 1995) (on file with the Washingtonand Lee Law Review) (same). The Derivatives Policy Group, which consists of six majorOTC derivatives dealers, promulgated FRAMEWORK FOR VOLUNTARY OVERSIGHT mcooperation with the SEC and CFTC. DERIVATIVES POLICY GROUP, supra, at 1. TheFRAMEWORK FOR VOLUNTARY OVERSIGHT sets out, among other things, a code of conductfor dealing with denvatives customers that the members of the Derivatives Policy Group havevoluntarily 'agreed to follow. Id. at 1, 37 Likewise, PRINCIPLES AND PRACTICES FORWHOLESALE FINANCIAL MARKET TRANSACTIONS, which was drafted by representatives ofthe Federal Reserve Bank of New York and several financial industry groups, provides avoluntary set of standards and principles governing the relationship between derivativesmarket participants. PRINCIPLES AND PRACTICES FOR WHOLESALE FINANCIAL MARKETTRANSACTIONS (1995).

224. See Derivatives Market: Hearings Before the Senate Comm. on Banking, Housingand Urban Affairs, 104th Cong., 1st Sess. (1995) (statement of Alan Greenspan, Chairman,Federal Reserve Board) (analyzing derivatives dealer-customer relationship).

225. See BT Securities, SEC, supra note 119 (involving derivatives transactionsrecommended by dealer); see also supra note 14 and accompanying text (describing allegedadvisory nature of derivatives dealer-customer relationships).

SUITABILITY REQUIREMENTS

dealer's responsibility to advise the customer fairly "6 Nonetheless,customers should recogmze that derivatives dealers that act in an advisorycapacity have conflicting interests and should treat dealer recommenda-tions accordingly Customers can either rely on their own judgment orseek advice from tlurd party consultants.2 2 7 The Group of Tiurty's studyconcluded that market participants can evaluate for themselves the risks andbenefits of trading with unregulated derivatives dealers.228 Indeed, thepublicity surrounding the huge losses suffered by some derivatives tradershas raised the consciousness of the average unsophisticated derivativescustomer.2 9

Suitability requirements for derivatives dealers enacted to protect cus-tomers seem mconsistent with the ideals underpinning the federal securitieslaws. Whereas securities disclosure provisions seek to protect the averagehousehold investor, derivatives customers are typically major corporationsor professional money managers. 30 Furthermore, whereas securities dis-closure provisions endeavor to promote confidence and participation in thesecurities market, suitability requirements may effectively deny unsophisti-cated customers access to the derivatives market because the costs of com-pliance with suitability requirements may dissuade dealers from dealingwith such customers.231

Moreover, the antifraud provisions of the federal securities laws andthe CEA arguably obviate the need for suitability requirements. Thus far,one aggrieved derivatives customer that sued a dealer claiming fraud hassettled its suit successfully " In addition, the antifraud laws provide

226. See BT Securities, SEC, supra note 119 (involving advisory relationship in whichdealer misled client as to value of client's derivatives contracts); Derivatives Market:Hearings Before the Senate Comm. on Banking, Housing and Urban Affairs, 104th Cong.,1st Sess. (1995) (statement of Alan Greenspan, Chairman, Federal Reserve Board)(discussing advisory nature of some derivatives dealers' relationships with customers).

227 See Saul Hansell, Derivatives Draw More Scrutiny, N.Y TIMES, Jan. 3, 1995, atC39 (describing derivatives consulting business as fastest growing segment of derivativesmarket).

228. GRoup OF THIRTY, supra note 62, at 63.

229. See supra notes 8-15 and accompanying text (describing recent well-publicizedevents involving derivatives).

230. See Culp & Mackay, supra note 41, at 46 (stating that overwhelming majority ofOTC derivatives customers are sophisticated institutional investors).

231. See id. (arguing that suitability requirements will prompt dealers to avoid lesssophisticated customers).

232. See supra note 15 and accompanying text (describing Gibson's settlement with BTSecurities).

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broader coverage than the current suitability regulations because antifraudlaws apply to derivatives transactions with unregistered dealers.233

In the alternative, suitability provisions may be unnecessary becausemarket factors will force dealers to ensure that recommended derivativestransactions are appropriate for unsophisticated customers. Because suita-bility is a creditworthiness concern,2 34 a dealer that enters into a derivativestransaction as a counterparty has an incentive to ensure that the transactionis appropriate for the customer.23 ' Likewise, the market motivates denva-tives dealers to ensure customer satisfaction and to protect their reputationsfor fairness.

V Conclusion

While laws requiring a dealer to consider whether a proposed denva-tives transaction is appropriate for a customer enhance credit risk manage-ment by dealers and reduce systemic risk, suitability requirements aimedat protecting unsophisticated derivatives customers are both unnecessaryand harmful. The current regulatory regime requires most derivativesdealers to observe the antifraud provisions of the federal securities acts andthe CEA and thus adequately protects customers.

233. See Order Exempting Certain Brokers and Dealers From Broker-DealerRegistration, supra note 156, at 4 (subjecting unregistered derivatives dealers to antifraudprovisions of federal securities laws to extent that dealers offer and sell securities).

234. See supra note 177 and accompanying text (explaining that suitability is relevant increditworthiness analysis).

235. See Culp & Mackay, supra note 41, at 46 (observing that because most derivativestransactions create long term credit exposures, dealers have incentive to ensure counterpartysuitability).

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